Mergers and acquisitions ("M&A") are complex, multilayered transactions with multiple moving parts and a healthy dose of negotiation. There are, however, common tax implications at play in most transactions of which purchasing and selling entities should consider, as these tax implications may guide significant aspects of negotiation in the deal.
Structure Means Everything
The starting point for evaluating tax implications associated with M&A transactions is the structure of the transaction itself. There are several ways to structure M&A transactions, and the most commonly used structures are asset purchases and stock purchases. There is also a wide range of possibilities in which an M&A transaction will be taxed - fully, partially or not at all.
A stock sale takes place between the purchaser of the target company and the shareholders of the target company, not the company itself. Therefore, the target company does not recognize any corporate-level gain. This is beneficial for the target company and its shareholders, as the transaction only receives single taxation (at the shareholder level) and avoids potential double-taxation involved with asset sales - once at the corporate level and once again at the shareholder level. In a stock sale, however, neither the purchaser, nor the target company, receives any stepped-up basis in its assets.
Asset sales, on the other hand, provide the purchaser with a favorable step-up in the depreciable basis in the acquired assets to fair market value. Sellers, however, often experience unfavorable tax treatment in an asset sale for two primary reasons. First, if the entity being sold is a C corporation, the seller will typically be subject to double taxation, as the corporation is taxed on the gain from the sale and the shareholders are then taxed on any proceeds they receive individually. Additionally, if the company is an S corporation but was formerly a C corporation, there is a 10-year tax recognition period for built-in gains ("BIG"), and a sale during that period could subject the seller to corporate BIG taxes. Second, although sales of capital assets are generally taxed at lower capital gains rates, such capital asset sales may be subject to depreciation recapture taxed at ordinary rates, and non-capital assets may be taxed at ordinary income tax rates as well - both resulting in increased tax liability for the seller.
Subject to a myriad of requirements, IRC Section 368 allows for C and S corporations to participate in a "tax-free reorganization." All tax-free reorganizations, however, require the seller, as part of the consideration for the transaction, to take back stock in the acquiring entity. The minimum value of stock compared to the total consideration paid by the buyer to the seller in a tax-free reorganization is 40 percent. Additionally, M&A transactions that otherwise qualify for tax-free reorganization treatment will be taxable at least to the extent of any cash received by the seller.
Beneficial Attributes of the Target Company
The target/selling company in an M&A transaction may have tax attributes that an acquiring entity should consider during the negotiation process and in structuring the deal. As a general rule, if the target has net operating loss carryovers, tax credit carryovers or a high tax basis in its operating assets, a tax-free reorganization or a stock transaction may be more advantageous than an asset purchase. However, the acquiring entity needs to consider the potential impact that IRC Section 382 may have on the ability of the acquiring entity to utilize and benefit from the target company's tax attributes.
If the target company is an S corporation, a partnership or a limited liability company, IRC Section 338(g), 338(h)(10) or 754 (in the case of a partnership) elections may still allow for the tax basis of the assets to be revalued - even in a stock transaction. While the aforementioned tax elections are particularly valuable to the acquiring entity, they often create a heavier tax burden for the seller and impact negotiations accordingly. Additionally, the tax elections under IRC Section 338 require that a minimum of 80% of the seller's stock is acquired by the acquiring entity, and special rules apply concerning asset transfers in the time period surrounding the stock sale to prevent the purchaser and seller from gaining step-up or loss benefits on certain assets.
Don't Pass the SALT
In structuring and negotiating M&A transactions, it's important not to overlook potential state and local tax ("SALT") implications. The SALT implications of M&A transactions can very vastly from jurisdiction to jurisdiction, and they often add layers of complexity to already complex transactions. Sales and use tax, excise tax, gross receipt tax and registration or licensing fees are just some of the SALT taxes that can affect M&A transactions.
SALT implications often vary from jurisdiction to jurisdiction. For example, some jurisdictions impose sales and use taxes on certain types of tangible personal property transferred as part of an M&A transaction, while other jurisdictions may offer exemptions. Whether the transaction takes the form of an asset purchase or a stock purchase will heavily impact which of these taxes apply to the transaction, so SALT considerations should be kept in mind at the beginning of negotiations regarding the structure of the M&A transaction.
SALT issues can also enter the fray when a buyer expands the reach of the company through the transaction. As the geographical footprint of the company expands into other jurisdictions, so does the potential SALT liability in those jurisdictions. If the expansion reaches into states and other jurisdictions in such a way that creates "nexus" (a substantial economic connection), the SALT rules for those jurisdictions must additionally be considered. As a result, during the due diligence and planning stage of a transaction, it is important to consider whether the transaction will create nexus with new states and expose the acquiring entity to SALT in those new jurisdictions.
Finally, successor liability for the unpaid taxes of the target corporation can attach to the acquiring entity regardless of the structure the M&A transaction takes. Several states impose successor liability for sales, use and employment taxes when an acquiring entity purchases all or s substantially all of a selling entity's assets. The acquirer should take particular care during due diligence to uncover such potential liabilities, and unpaid tax liabilities should then be a point of negotiation of the purchase price and indemnification obligations and related escrow amount.
A Starting Point for M&As
The above tax considerations serve as a basic starting point for delving into the more complex and tedious tax issues associated with M&A transaction. M&A transactions require delicate tax planning and negotiation on a case by case basis to ensure that the represented party receives optimal tax treatment from the deal.